Consumer spending cutbacks nail retail bonds

As investors demand more to hold debt, returns are sluggish, likely to stay that way

By

DeborahLevine

NEW YORK (MarketWatch) - The retrenchment in consumer spending is making it increasingly expensive for retail companies to raise public debt and punishing returns for holders of their outstanding bonds, a situation that's unlikely to change any time soon, analysts say.

As U.S. consumers tightened their spending on shopping, eating out and entertainment, corporate bonds sold by companies in these sectors have returned just 0.88% this year, according to an index compiled by Merrill Lynch & Co. In contrast, U.S. Treasurys, the harbor for investors seeking safety, have gained 2.22% in 2008.

'The economy is not going to be doing well and the consumer is stressed." - Thomas Atteberry, First Pacific Advisors.

Analysts expect the outlook for corporate bonds to remain dour.

"The economy is not going to be doing well and the consumer is stressed," said Thomas Atteberry, who manages $3.5 billion in fixed income assets for First Pacific Advisors. "It's not a good environment for high yield and all other corporate bonds."

On Tuesday, Office Depot
ODP, -0.97%
warned its North American same-store sales declined nearly 10% in the second-quarter and said it continued to be hurt by a "challenging economic environment." Office Depot's shares fell as much as 37%. See related story.

Profits for consumer discretionary companies are slated to post an 18% drop in the second quarter, according to estimates compiled by FactSet Research.

Consumer spending has been increasing at the slowest pace since 2003, annual changes in the government's personal consumption expenditures data show. Economists note that spending in the last couple months has been heavily boosted by recent tax rebates, although that support is likely to wane later this year.

Besides slower consumer spending, many companies are facing higher raw materials costs. And any company that has to transport its goods has to account for skyrocketing oil prices.

Although energy prices fell broadly Tuesday, crude oil futures prices are still up 47% so far this year while gasoline prices have gained 40%. Read more on commodities.

"A lot of companies are ill-positioned to deal with the double whammy of higher input costs" alongside decelerating growth in the U.S. and Europe, said Mark Howard, head of credit analysis at Barclays Capital, at a news conference in late June.

For restaurants and food companies, corn futures' 60% jump this year and sugar's 25% gain have also been undercutting profits.

Nervous investors force yields higher

As a result of increased costs and slowing spending, investors have increasingly demanded higher yields for holding corporate debt.

Pacific Investment Management Co. is "avoiding U.S. consumer-sensitive industries where margins are under pressure due to falling housing prices, tighter consumer credit and rising input costs," wrote Mark Kiesel, who manages corporate debt portfolios for the firm, in a report release July 2. Pimco manages about $812 billion in assets.

Less interest in using debt

Higher yields, or borrowing costs, have made it less attractive for retail companies and others to issue new debt this year.

The amount of investment grade corporate debt sold in the first half of the year fell 9% from the same period in 2007, to $413.2 billion, according to data tracker Dealogic.

Issuance was more voluminous in the second quarter than the first, when $240.3 billion was sold. That includes the $108.7 billion sold in May, a record for a single month.

"July should continue the relatively modest pace of issuance as this is seasonally a slow month and the credit market remains weak," Bank of America analysts Hans Mikkelson and Mike Cho wrote in a research report dated July 1.

The firm also downgraded food, beverage and tobacco debt, suggesting investors keep the weighting of their portfolio allocation to those sectors even to their benchmarks. It recommends underweighting department stores, restaurants and specialty retailers.

"Weakness in the consumer products, media and entertainment, and retail/restaurants sectors is a result of U.S. consumers' diminished economic prospects" and these sectors have the highest levels of credit stress, said Diane Vazza, head of Standard & Poor's Global Fixed Income Research Group, in a statement.

Companies are running under tighter operating and profit margins, which "raises concern about both the failure to meet financial covenants and growing financial leverage during a difficult economic environment."

Consumer products, media and entertainment and retail and restaurant debt consistently top the list of so-called distressed companies, which carry speculative-grade ratings and trade in excess of 1,000 basis points above Treasurys, Vazza said in a report. A basis point is one one-hundredth of a percent.

Even with already low ratings, many are also at risk for another downgrade by the ratings agency. Plenty of well-known companies with non-investment grade ratings, defined as anything below BBB-minus by Standard & Poor's, are also vulnerable to further downgrades, she said.

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